I have written often about the differences between passive “buy-and-hold” investing and actively managed strategies such as the ones Halbert Wealth Management offers in our AdvisorLink® Program. Most often, these two types of investment strategies are viewed as being in competition with each other for investor dollars.

Yet during the worst of the 2007–2009 bear market in stocks, articles were everywhere saying that buy-and-hold was dead. In fact, I wrote a couple of them myself. You will recall that the S&P 500 Index plunged over 50% during the bear market, and many investors bailed out near the lows. However, those buy-and-hold loyalists who kept the faith have now been rewarded with a huge market rally fueled by primarily government intervention.

No matter what the reason, the market’s rally off of its March 2009 low has breathed new life into passive investment strategies. The old adage that “the market always comes back” is now being heard again. In fact, through February the S&P 500 soared an incredible 96% since the lows in early March 2009, bringing it within striking distance of its October 2007 all-time high.

Of course, active managers note that if we reach the October 2007 peak value again, that simply means that the market has reached the breakeven point, and many of those investors who stayed in will see their portfolios get roughly back to where they were before the credit crisis began.

As we counsel the many investors who call us on a weekly basis, we are finding that many are not clear on exactly what passive and active management strategies are. There are so many terms used in the industry, some with multiple meanings, that it’s not uncommon for investors to be confused. Couple that with deliberately misleading information put out by opponents of active management, and it’s easy to get to a point of “analysis paralysis.”

In this week’s E-Letter, I will highlight the basics of both active and passive investment strategies, discussing both the positives and negatives of each. I’ll also try to clarify some of the terminology used when discussing these strategies.

This will be a good E-Letter to save for future reference, as well as one that you will want to send to friends and family members who may benefit from the information. They can also sign up for a free subscription to this weekly E-Letter at www.forecastsandtrends.com.

Basics of Passive, Buy-and-Hold Investment Strategies

While an investor might buy virtually any investment and hold it for the long-term, my analysis will center on buy-and-hold “asset allocation” strategies that are so popular in the financial advisory world. Most of the asset allocation strategies are based upon Nobel Prize winning work done by Harry Markowitz, and fall under the heading of Modern Portfolio Theory (MPT).

In a nutshell, MPT is an investment theory that claims to be able to provide optimum risk-managed returns by allocating money among a group of asset classes with varying levels of correlation to movements in the markets. In other words, expected returns are based on the specific level of risk the investor wants to take on. Asset classes are various categories of investments such as stocks, bonds, real estate, tangibles, cash, etc.

This diversification of investments is designed to help manage risks, since different asset classes in a portfolio are expected to go up or down independently of each other to the extent possible. Consequently, many current discussions of MPT label the strategy as “diversification” rather than asset allocation, giving the impression that other types of strategies are not diversified, which is not always accurate.

The specific mix of asset classes within any given investor’s portfolio will be based on a variety of factors, including the investor’s time horizon, risk tolerance and investment experience. A whole host of software applications have been developed to take input from investors and generate a potentially optimum mix, known as the “efficient frontier,” a term derived from the fact that MPT is based on an assumption that investors are rational and markets are efficient.

MPT-based strategies usually call for investments to be rebalanced over time. In addition, changes in an investor’s financial situation or risk tolerance should also dictate changes to the portfolio as needed. In reality, however, many diversified accounts are seen as a “set it and forget it” strategy where investments are simply bought and held for the long term.

While allocations are typically made to a wide group of assets, portfolio performance generally tends to be correlated to the stock markets. Thus, asset allocation strategies tend to be judged based on their performance relative to a market index or group of indexes and are known as “relative return” strategies.

Strengths of Buy-and-Hold Investing

MPT-based asset allocation strategies are probably the most popular investment strategies used today. One reason for this is the fact that these strategies lend themselves to computer modeling and illustration. I’m sure everyone is familiar with the colorful pie charts showing the allocation of each asset class. Other advantages of passive asset allocation strategies are:

As relative return strategies, asset allocation strategies tend to be viewed as successful if they limit losses to less than what are incurred in the broad stock market. Portfolios are considered to “beat the market” if they have a higher gain than their market benchmark, or if they post smaller losses.

。uy-and-Hold strategies tend to do well compared to other strategies when markets go straight up. Such was the case in the late 1990s during the tech boom, and during the impressive rally since March of 2009. Thus, passive strategies are beneficial when high correlation with the stock market is a good thing;

、sset allocation strategies tend to work well when used along with “dollar-cost-averaging,” a technique where money is invested slowly over time, such as in a 401(k) plan. This allows for investments to be made in both up and down markets over time;

ヾince trading tends to be infrequent and many brokers use low-cost index funds, buy-and-hold strategies tend to be lower cost than active strategies. Plus, positions tend to be held for longer durations, so buy-and-hold strategies are often more tax efficient than more active strategies; and

、s a general rule, asset allocation strategies are easy for clients to understand and have gained widespread acceptance by the general public as well as the brokerage and financial advisory community.

Buy-and-Hold Disadvantages

There is no perfect asset management strategy, including buy-and-hold. I once heard a motivational speaker note that a weakness is simply a strength out of control. That is somewhat the case with buy-and-hold, in that some of its advantages can become major disadvantages in certain market environments (read: bear markets).

For example, the tendency for asset allocation strategies to be correlated to major market indexes can be a huge detriment when the market goes down. Recent history has shown that asset classes that are not highly correlated during bull market phases can actually become highly correlated during bear markets. Thus, just when non-correlation is needed to manage risk, it can disappear virtually overnight. When virtually all asset classes decline, such as in 2008, asset allocation becomes a “no brakes” strategy. Other disadvantages of buy-and-hold strategies include:

、sset allocation strategies require a lot of emotional stability, especially during times when the market is plummeting and an investor’s account is following suit. While advisors preach “stay the course,” studies show that investors bail out at the worst possible time, realizing the losses and missing out on any subsequent rally;

Buy-and-hold strategies are often sold based on illustrations showing extremely long-term projections of stock returns. While that’s fine for a corporation, foundation or other entity, it’s typically not reflective of the time horizons applicable to most individual investors. Plus, claims that the market “always comes back” may or may not be true. Try telling that to someone who invested their money in a Nasdaq Composite index fund in 1999 before the tech crash;

There’s no such thing as a “set it and forget it” investment strategy, and asset allocation is no exception. At the very least, investment positions should be “rebalanced” periodically. Unfortunately, many investors fail to do this, much less re-evaluate each position every year, and many allocations are left unchanged for years; and

Other than adjusting for time horizons and risk tolerance, buy-and-hold strategies tend to be a “one size fits all” strategy. This makes it easy for the computer illustrations and salespersons, but may not provide enough flexibility for all clients.

Basics of Active Investment Strategies

Before proceeding further, it’s important to note that there is more than one definition for “active management.” The mutual fund industry defines active management as involving a hands-on manager or group of managers who attempt to select stocks and/or bonds that offer the potential for higher returns than the fund’s benchmark index. This is in contrast to passively managed mutual funds, which simply try to emulate the performance of a market index.

The problem is that most active mutual fund managers cannot beat the performance of the passive index funds. Study after study has shown that most mutual fund managers cannot beat the market, especially when factoring in the higher management costs. However, such studies can be misleading in that they are not comparing the same kind of active and passive management that I am discussing today.

Active management, for purposes of this article, generally includes strategies that involve the use of impartial, systematic approaches to managing money on a continuous basis. These strategies seek to react to market forces in order to take advantage of opportunities and/or avoid losses. Holding periods for investment positions can range from one day to several years, depending upon the particular strategy.

As an example, a strategy that seeks to be invested in the market during upward trends and in cash during down markets is a common active management strategy. Others include strategies that are most typically found in hedge funds, including the use of sector rotation, leverage, hedging techniques and a variety of other strategies.

Some active management strategies focus on a single asset class or market index, while others invest among a broad range of asset classes and markets. So-called “inverse funds” are also available that allow investors and active money managers to hedge their long positions during bear markets and downward corrections without having to sell open positions. Inverse funds go up in value when the market goes down. These same funds can even be used to enter a “net short” position to make money in declining markets.

It is important to note that active investment strategies range from more conservative to very aggressive in terms of the returns they target. There are some strategies that intentionally seek outsized returns, and these strategies can be quite volatile on the upside and the downside periodically. Ditto for strategies that use leverage and long/short trading.

Carefully selected aggressive strategies can have an important place in a diversified portfolio. Such strategies should only be used by investors with a sufficient risk tolerance and generally should only represent a small part of one’s overall investment portfolio. Even so, for those who can tolerate the volatile nature of these strategies, they have the potential to add to overall returns.

Advantages of Active Management Strategies

As a general rule, active management strategies tend to have low or no correlation to major stock and bond market indexes or to buy-and-hold asset strategies. This makes them an excellent source of diversification and provides investors with additional flexibility.

However, the biggest advantage enjoyed by successful active management strategies is related to investor behavior. I noted above that studies have shown that investors make emotional decisions to exit the market when losses become uncomfortable. If an active management strategy can minimize these losses by going to cash or hedging long positions, then it stands to reason that investors may remain invested and not bail out at the wrong time.

Not only does minimizing losses help investors avoid emotional decisions, but it can also mean quicker recovery from down markets. I have written before about the importance of minimizing losses and how much more in return it takes to come back from an investment loss. Many investors believe that it takes a 20% gain to come back from a 20% loss, but that’s not true. It actually takes a 25% gain to erase a 20% loss. Even worse, the greater the loss, the more gain must be earned just to get back to breakeven.

The breakeven table below illustrates this important point. You can see that a 10% loss takes just a little over 11% to get back to breakeven. However, a 50% loss like that incurred by the S&P 500 Index in 2008 requires a 100% return just to get back to breakeven.

Amount of Loss Incurred

Return Required to
Break Even

10%

11.1%

15%

17.7%

20%

25.0%

25%

33.3%

30%

42.9%

35%

53.8%

40%

66.7%

45%

81.8%

50%

100.0%

60%

150.0%

70%

233.3%

Most investors don’t know this, but historically the stock market is either in a bear phase or trying to make up losses incurred during down markets60% of the time. The implication is clear – if you can limit losses in down markets, you have the potential to use subsequent rallies to build your wealth rather than just getting back to the breakeven point.

There are also other advantages of active management strategies, including:

There is a wide array of active management strategies in both stocks and bonds. The variety of active strategies allows investors to select those that best fit their investment goals and risk tolerance;

While individual investors can engage in active investing on their own, I do not recommend that you do so. Using a professional money manager allows you to pursue the things you enjoy rather than sitting at a computer watching the stock and bond markets all day;

Successful aggressive strategies that use long and short trading techniques offer the potential to not only reap outsized returns, but also the ability to make money even when the market is declining;

Some active strategies seek to produce “absolute returns,” which are consistent positive returns without regard to the direction of the market. These strategies are beneficial to those who need to have consistent returns for income purposes; and

、s a general rule, active management strategies are designed more around meeting the needs of the individual investor rather than the general goal of “beating the market.”

Disadvantages of Active Management Strategies

Active management strategies also have their disadvantages. One of the most obvious is that most individual investors that try to actively manage their own investments meet with failure. This observation is based on studies by Dalbar, Inc. and others that show retail mutual fund investors generally do not realize the long-term returns delivered by mutual funds because of frequent switching, usually at inopportune times (buying high and selling low).

That’s why I have always counseled investors to seek out the services of professional active money managers rather than going it alone. However, it may surprise you to hear that even most professionals who try active management are not successful. During our 15+ years of searching for successful active money managers, we have found that most are mediocre, some are downright terrible, but a select few have very attractive long-term track records.

[Note: At Halbert Wealth Management, we try to minimize the chances of selecting the wrong Advisor by making all of the money managers we recommend in our AdvisorLink Program pass our rigorous due diligence review. However, just because a money manager has been successful in the past doesn’t mean that the trend will continue. That’s why we monitor performance and trading of all of our recommended Advisors on a daily basis.]

Other disadvantages of actively managed strategies include:

Since active management strategies tend to trade more frequently, they are often not as tax efficient as buy-and-hold strategies. For this reason, some investors choose to place their actively managed investments in a tax-qualified account such as an IRA or variable annuity;

Some strategies perform well during certain types of market environments but poorly in others. A good example is the tech bubble of the late 1990s when the market was going straight up. Some active management strategies perceived elevated risk during this time and stayed largely out of the market. But by doing so, they missed the crash in 2000;

Active management strategies tend to be more expensive than buy-and-hold, but it’s important to not judge a manager solely by the fee. Always evaluate investment managers based on performance net of all fees and expenses to see if they add value over and above their increased costs; and

：inally, active management strategies can sometimes be more confusing for the average investor than a straight-forward asset allocation plan. Many active strategies are based on proprietary trading models that are closely guarded by the Advisor, much as is the case in hedge funds. That’s another good reason why it’s important to have a mediator on your side who can help evaluate the strategy and monitor its ongoing trading.

Conclusions

Buy-and-hold and active management are both equally valid investment strategies. I actually have some of my own money in both. However, I have the bulk of my net worth invested in the actively managed strategies we recommend. Why? Primarily because I want most of my money invested with professionals who have the ability to move to cash or hedge long positions during market declines. And I don’t like losing 50% as many buy-and-hold strategies did in 2008.

A lot of money moved from buy-and-hold into actively managed strategies following the recent bear market. It is too bad that it took one of the worst bear markets in history to shine the light on active management strategies. I have been writing about them and seeking out the successful active managers since 1995.

For readers who have always used the buy-and-hold approach, I highly recommend that you seriously consider the active managers I recommend for at least a part of your portfolio.

While buy-and-hold advocates swear that it is impossible to time the market, that is simply not true. While there are probably more active management strategies that have not been successful versus those that have been successful, there are plenty of active management strategies that have been profitable and reduced risk for many years.

The key is, how do you find the successful active managers? Unfortunately, this is tough for most individual investors since most active money managers don’t advertise. That’s where Halbert Wealth Management comes in. We continually search the universe of professional money managers looking for successful active managers. We attend conferences where these money managers gather. And we subscribe to multiple services that track these managers.

When we find them, we conduct a thorough due diligence visit in the manager’s own offices to check out their staff and review their actual performance record in real customer accounts. If we decide to recommend a money manager, the first money we place with them is my own. I have my own money invested with every manager we recommend.

When clients invest with one of the managers we recommend, they establish their own individual account(s) with a well-known custodian where the manager trades (Fidelity, Rydex, TDAmeritrade, etc.). That way, the client has complete control over the account, full transparency and daily liquidity. The client gives the manager authority to make trades in the account and withdraw management fees periodically.

Most of the managers we recommend invest in mutual funds offered by well-known fund families that you would recognize. Some of the managers we recommend are also increasingly investing in Exchange-Traded Funds (ETFs). Account minimums vary from manager to manager but some are as low as $25,000. Management fees also vary but are typically around 2-2.5% annually. The money manager shares a portion of that fee with Halbert Wealth Management for introducing the client, so there is no additional fee paid to my company by the investor.

We currently have over 10 different active managers that we recommend. We offer actively managed strategies in stock funds, ETFs and bonds (Treasuries, high-yield and convertible). If you are looking for the potential for superior returns with a lot less risk than buy-and-hold, I encourage you to check out the active managers we recommend.

To learn more about the actively managed strategies I recommend – where I have the bulk of my net worth invested – you can:

Give us a call at 800-348-3601 and ask to speak to one of our Investment Consultants;

On a final note, some readers are reluctant to invest with us because they live in some other part of the country than Texas. Frankly, that is not a problem. We have clients in almost every state in the nation, and we have never met most of them in person. Don’t let the fact that you live somewhere else keep you from participating in these risk averse active strategies!

Forecasts & Trends E-Letter is published by Halbert Wealth Management, Inc. Gary D. Halbert is the president and CEO of Halbert Wealth Management, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, Halbert Wealth Management, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.